Last spring, the IRS issued Revenue Ruling 2023-2 to clarify that assets held in an irrevocable grantor trust do not receive a step-up in basis at the grantor’s death. This may not have been a surprising revenue ruling for many practitioners. However, because it has now been publicized as a new ruling, clients have voiced concerns about how it impacts existing irrevocable trusts and future planning they may be considering.
What is the effect of Revenue Ruling 2023-2?
Any assets that were transferred to an irrevocable grantor trust will not receive a step-up in basis upon the client’s death. The effect of this ruling leads to potentially significant capital gains tax for trust assets that have appreciated significantly since being transferred to the trust.
Example: Client acquired X Corp stock in 2015 and his basis in the stock was $1 million. In 2020, Client transfers X Corp stock into irrevocable trust T with Child as the beneficiary. Trust T takes a transferred basis in the stock, meaning the stock retains the $1 million basis. Client passed away in 2023, and the fair market value of the X Corp stock at the time of Client’s death was $5 million. In 2024, Child is in need of liquidity and wants to sell the X Corp stock and make a distribution to himself. However, under Revenue Ruling 2023-2 a step-up in basis of the X Corp stock at Client’s death is not allowed. Therefore, the sale of the X Corp stock will result in a long-term capital gain of $4 million.
How does an irrevocable grantor trust differ from other irrevocable trusts?
An irrevocable grantor trust is a trust in which the assets are outside of the grantor’s estate for estate tax purposes; however, all trust income and gains are included on the grantor’s federal income tax return. Many estate planners steer their clients toward grantor trusts because the federal income tax paid on behalf of the trust does not count against the grantor’s federal estate and gift tax exemption.
What is a step-up in basis? Under the Internal Revenue Code, assets owned by a client receive a step-up in basis to the fair market value as of the client’s death. This can provide a significant tax benefit to the beneficiaries of a client who owned highly appreciated property. A step-up in basis can dramatically lower the capital gains tax owed upon the sale of inherited property. However, estate planners often recommend transferring appreciating assets during a client’s lifetime, which results in the assets losing a step-up in basis at the client’s death.
What are important considerations in identifying assets for a client to transfer?
When determining which assets to transfer during a client’s lifetime, consideration must be given to (i) the client’s current estate tax exposure and the likelihood for assets to increase or decrease in value, (ii) the basis of the assets, (iii) the likelihood of an asset being sold after a client’s death, and (iv) the client’s cash flow needs.
Example: Client likely will not have estate tax exposure but wants to transfer wealth to younger generations during life. Client may consider transferring high basis assets or assets that are not likely to appreciate. By transferring such assets during life, Client accomplishes his goal of lifetime gifting to descendants but does not have to worry about estate tax exposure at death. Further, the assets retained by Client will receive a step-up in basis to fair market value at Client’s death, which prevents future significant capital gains tax when a beneficiary sells inherited assets.
What can be done if an irrevocable grantor trust holds assets with a significant built-in gain?
Several strategies can be considered when clients are concerned about irrevocable grantor trusts that hold assets with significant built-in gains. For example, if the client has sufficient cash or high basis assets, the client could purchase or substitute the low basis assets from the trust for fair market value. Then, at the client’s death, the low basis assets (now owned by the client) would receive a step-up in basis to fair market value and the high basis assets (now owned by the trust) would already have a favorable basis. This strategy does not trigger income tax upon the purchase or substitution by the client.
Who should be concerned about this?
Generally, every client with an irrevocable grantor trust should have some level of concern about this ruling. Of particular concern are clients who have successfully transferred appreciated assets to irrevocable grantor trusts.
How can we help?
If your clients previously transferred assets to an irrevocable grantor trust that have significantly appreciated in value, we can help them strategize methods to remedy this looming built-in gain problem. Further, if you have a client who is considering making gifts, we can help you and your client identify appropriate assets for gifting.
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